What You Want vs. What You Need

“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” - John Maynard Keynes

 “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” ― Sam Ewing

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We all understand the destructive effects of inflation has over time but what happens when inflation is as low as it has been over the past 20 years? What you say, inflation has not been low? Your personal experiences says otherwise? Our Government’s Bureau of Labor Statistics (BLS) begs to differ. Prices on average over the past 20 years has been 55.6% which works out to be an annualized rate of ~2.02%. One of the lowest 20 year periods …. Ever. So who’s right?

 The problem as we uncover when peeling back the onion, is how the BLS calculates its numbers. To avoid going down that rat hole into a hornets nest, it’s safe to say that inflation is the sum of the prices of things that are rising and the rest that are rising more. Unfortunately, as it works out, the things that you want are rising while the things you need are the things that are rising more. This has never been so apparent than in the most recent 20-year data presented in the chart below.

 One scrutinizing the chart may point out that food and beverage prices (a need) have been rising at an “average” rate. The devil is in the details here too. Looking under the hood you will see the things that are healthier (unprocessed and natural foods) are rising at a much faster rate than things like fast food. Oh and while I do have some millennial readers, no, cellphone service is NOT a thing you need.

Uh Oh

It should be no surprise to anyone bond yields are rising. What may be of surprise is that we MAY have just turned the corner and entering our first bond bear market in more than 30+ years.  As you can see in the 5-year weekly chart of 10-year US Treasury bond yields that we just broke out from a rounded base which target projects up to 2013’s high water mark, labeled T1.

While this chart may not look as if it has formed a bearish reversal (bear market), turning to the much longer-term view of Treasury 10-year rates we see they have broken and closed above their downtrend line for the first time in 30+ years. Breaks of downtrends are interesting but carry less weighting without higher highs and higher lows being formed. Without them, its more than likely to turn out to be just a counter-trend bounce.

While this is definitely a HUGE yellow caution flag, my interpretation is that until they break and hold above (not just rise up to) 2013’s peak, I would not be overly concerned. Why? Because virtually everyone is aware (the FED has been telling us they will be raising rates for eons) and the smart money is positioned accordingly. Markets move most when most involved are surprised, which is not the case here. As such, I fully expect the market to do exactly what you would expect it would do when everyone knows what is coming … the exact opposite of what is expected. So, until this reversal question is finally resolved, because of bonds effect on other investments, there are potential major changes on the horizon. I don’t need to say it but we are in interesting times and investors need to keep a close watch on what unfolds with intermediate and longer-term bonds in the weeks and months ahead.

December 2017 Charts on the Move Video

I do a quick recap on 2017 and take a look at what 2018 will likely bring for investors in this months Charts on the Move video.

https://youtu.be/KrBsM59DhM8

It's Coming, Are You Ready?

Automation may wipe out 1/3 of America’s workforce

In a new study that is optimistic about automation yet stark in its appraisal of the challenge ahead, McKinsey says massive government intervention will be required to hold societies together against the ravages of labor disruption over the next 13 years. Up to 800 million people—including a third of the work force in the U.S. and Germany—will be made jobless by 2030, the study says.

The bottom line: The economy of most countries will eventually replace the lost jobs, the study says, but many of the unemployed will need considerable help to shift to new work, and salaries could continue to flatline. "It's a Marshall Plan size of task," Michael Chui, lead author of the McKinsey report.

In the eight-month study, the McKinsey Global Institute, the firm's think tank, found that almost half of those thrown out of work—375 million people, comprising 14% of the global work force—will have to find entirely new occupations, since their old one will either no longer exist or need far fewer workers. Chinese will have the highest such absolute numbers—100 million people changing occupations, or 12% of the country's 2030 work force.

The details:

• Up to 30% of the hours worked globally may be automated by 2030.
• The transition compares to the U.S. shift from a largely agricultural to an industrial-services economy in the early 1900s forward. But this time, it's not young people leaving farms, but mid-career workers who need new skills. "There are few precedents in which societies have successfully retrained such large numbers of people," the report says, and that is the key question: how do you retrain people in their 30s, 40s and 50s for entirely new professions?
• Just as they are now, wages may still not be sufficient for a middle-class standard of living. But "a healthy consumer class is essential for both economic growth and social stability," the report says. The U.S. should therefore consider income supplement programs, to establish a bottom-line standard of living.
• Whether the transition to a far more automated society goes smoothly rests almost entirely "on the choices we make," Chui said. For example, wages can be exacerbated or improved. Chui recommended "more investment in infrastructure, and that those workers be paid a middle wage."
• Do not attempt to slow the rollout of AI and robotization, the report urged, but instead accelerate it, because a slowdown "would curtail the contributions that these technologies make to business dynamism and economic growth."

One Man’s Junk

Because the bond market is so large in comparison to the stock market, it can be worth monitoring for clues as to what may be in store for stocks. That might seem counterintuitive but stocks are simply a measure of investor’s appetite for risk. Within the bond market, junk (high yield) bonds take on the same role.  As such, junk bond prices normally move in unison with stocks. When they diverge, like they did last week, should give investors a hint that something may be afoot.

In the upper pane of my chart below is a plot of SP500 price (in red) and the junk bond ETF, JNK, in blue. The bottom pane is a smoothed correlation coefficient of the two investments, which has hovered near 1 (perfect correlation) for most of the past year.  As you can see that while the movements can vary in the size of the movement, the direction is almost always in the same direction. That is except for two times which I have identified within the purple ellipses. The first time being last April when stocks fell briefly while junk bonds rose. The second being the last few weeks as junk bonds have fallen substantially while stocks continue to rise.

All divergences, this one included, are warning signs to investors that something (or someone in this case) is wrong. The question one has to ask is, is it the bond investors or stock investors who have it wrong.  Are stocks ready to follow junk bonds lower? Or is this just another example of market makers playing games with junk bonds and it eventually turns out to be a wonderful buying opportunity?  The answer to these and other questions will only be known in the rear view mirror but until then the divergences should be viewed as a cautionary yellow flag for investors.